By Anthony Diosdi
For those who are or will be involved in international business and investment transactions, it is important to have some basic understanding of the relevant tax laws. These series of articles are intended to warn individual shareholders of controlled foreign corporations (“CFCs”) (whether individual or corporate) of the mistakes that will likely catch the attention of the Internal Revenue Service (“IRS”) and trigger a potential costly audit.
The transition from a worldwide income system to a hybrid territorial system via a participation exemption (i.e., a deduction for dividends received from a foreign corporation) has brought about a one-time repatriation tax on the earnings and profits (“E&P”) of a foreign corporation. The United States now has a hybrid territorial system to tax offshore income at a rate of 21 percent. This has been welcome news for large multinational corporations. On the other hand, the new hybrid tax system has resulted in significantly higher taxes to small CFCs that are owned by individuals. Understanding these new hybrid tax laws have added another level of complexity to international taxation- an area of tax law that was extremely difficult to comprehend. The new hybrid tax system has introduced new classifications of income or tax regimes. As it relates to losses, the treatment of one category of income operates in virtual silos. In certain cases, losses relating to one category of income cannot be utilized to offset other categories of income. The offsetting of one type of foreign income against another type of foreign income can catch the attention of the IRS and trigger a costly audit.
Losses of Legacy Subpart F Income
Under the 2017 Tax Cuts and Jobs Act, new rules requiring the inclusion of global intangible low-taxed income (“GILTI”) produced by CFCs were added to the Internal Revenue Code. GILTI essentially taxes CFC shareholders on their allocable share of earnings from a CFC, to the extent that the earnings exceed a ten percent return on tangible assets allocated to its shareholders. Most CFCs generate GILTI. Prior to the enactment of the 2017 Tax Cuts and Jobs Act, most CFCs generated subpart F income. The subpart F provisions of the Internal Revenue Code continue to apply to certain passive income, investments in U.S. property, related-party sales and service operations, and insurance income.
Prior to the enactment of the 2017 Tax Cuts and Jobs Act, CFCs typically generated subpart F income and losses. A number of CFCs established prior to tax reform have legacy subpart F losses on their books. These same CFCs now may only be generating GILTI income and not subpart F income. There may be a temptation to offset legacy subpart F losses against current GILTI inclusions. We have noticed a number of tax professionals attempting to do just that. This can result in a costly error. Utilizing losses from subpart F income against GILTI income or vice versa will probably catch the IRS’ attention and trigger a costly audit. This is because the treatment of subpart F and GILTI losses operate in virtual silos. Losses from Subpart F operations cannot be utilized to offset GILTI income and vice versa. So think twice before utilizing legacy subpart F losses against current GILTI income.
If you are concerned that about how to report your foreign source income and losses, you should consult with a qualified international tax professional. We provide international compliance assistance and international tax planning services to domestic corporations. We also assist other tax professionals who need guidance regarding international tax compliance matters.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.